Transcript ECONOMICS - University of Maryland, College Park

CHAPTER
Chapter 8
The Classical Long-Run Model
Part 1
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Economic Policy
• Normative and Positive economics.

Government borrowing increases interest
rates

The government role should be expanded in
the economy
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Economic Policy
•
Interesting and important question:
- Does government spending financed
by borrowing improve the economy’s
performance or make things worse?
• This has been debated for a long time,
most recently with the ARRA of 2009
- Its possible for both sides to be right. It depends
on long-run vs. short-run impact.
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Economic Policy
• Do the benefits of sort run impact out
weight cost associated with long-run
impact?
• We need to understand how the
economy operates in the short-run and
the long-run
• Chapter 8 addresses the long-run,
presenting the long-run classical model
• Chapter 10 begins the presentation of
the short-run model
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The Classical Long-Run Model
• Macroeconomic model that explains the
long-run behavior of the economy.
• We are talking about potential GDP. Look
back at figures 4 and 5 in chapter 6 and
the following slide.
• Developed by economists in the 19th and
early 20th centuries
• The argued that market forces drive the
economy toward full employment, possibly
quickly.
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Actual and Potential Real GDP, 1980–2014
Potential Real GDP
Actual Real GDP
Macroeconomics is concerned about both the trend
and fluctuations around the trend.
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Macroeconomic Models
Where are we Today
• Classical model
– Has proven more useful in explaining the
long-run trend itself
• Decades
• Keynes’s ideas and further development
help us understand economic fluctuations
• Movements in output around its long-run trend
• Quarter to quarter and year to year
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The Long-Run Classical Model
• Critical assumption about how the world
works:
Markets clear!
• The price in every market will adjust until
quantity supplied and quantity
demanded are equal
• A reasonable assumption if trying to
explain behavior of the economy over
decades
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The Long-Run Classical Model
• We use the classical model to answer the
following questions about the economy in
the long-run:
– How is the level of full employment
determined?
– How much output will we produce at full
employment?
– What is the role of total spending in the
economy?
– What happens when things change?
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How Much Output Will We Produce?
• Firms use resources (land, labor, capital
and ______ )to make the goods and
services that people demand
• We’ll focus on labor and the labor market.
• We assume:
– Firms are already using the available
quantities of the other resources
– Aggregate all the different types of labor
into a single variable, labor
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Start With The Labor Market
Labor Supply and Demand
• Households (you and I) supply labor
• Firms demand labor
• Graph
• Horizontal axis: number of workers
• Vertical axis: real hourly wage rate
Real wage (we measure all variables in real terms)
• Measured in the dollars of some base year
• The amount of goods that workers can buy
with an hour’s earnings
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The Labor Market
Labor supply curve
• Shows how many people will want to work
at various real wage rates
• Slopes upward
• As the real wage increases, more and
more individuals decide they are better off
working than hanging around the pool and
not working.
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The Labor Market
Labor demand curve
• Shows how many workers firms will want
to hire at various real wage rates
• Downward sloping
• Firms maximize profits. As the wage rate
decreases, each firm in the economy will find
to maximize profit, it should employ more
workers than before
• When all firms behave this way together a
decrease in the wage rate will increase the
quantity of labor demanded in the economy
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Labor Market Equilibrium
Real
Hourly
Wage
LS
A Excess Supply B
of Labor
$30
E
25
H
20
J
Excess Demand
for Labor
150 million =
Full Employment
LD
Number of
Workers
The equilibrium wage
rate of $25 per hour is
determined at point E,
where the upwardsloping labor supply
curve crosses the
downward-sloping
labor demand curve.
At any other wage, an
excess demand or
excess supply of labor
will cause an
adjustment back to
equilibrium.
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The Labor Market Equilibrium
Equilibrium full employment
• Market clears
• In the Classical Model the economy
achieves full employment on its own
• [Side Note: Keynes questioned this. How
can you have 25% unemployment and
assume the labor market “clears”.]
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From Employment to Output
Assumptions
• Quantities of other resources are fixed
• Technology is fixed
Aggregate production function
• How much total output the economy can
produce with different quantities of labor
when quantities of all other resources and
technology are held constant
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Aggregate Production Function
Y
output
L
labor
Output Determination in the Classical Model
Real
Hourly
Wage
LS
In the labor market, the demand
and supply curves intersect to
determine employment of 150
million workers.
$25
LD
Total Output
(Real GDP)
150 million
Number of Workers
Aggregate Production Function
$10 Trillion
=Full
Employment
Output
The production function shows
that those 150 million workers can
produce $10 trillion of real GDP.
The is full employment potential
GDP.
150 million
Number of Workers
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From Employment to Output
• Equilibrium real GDP
–In the classical long-run view the
economy tends towards its potential
full employment level of output on its
own.
–Later in the course we refer to this as
the “self-correcting” mechanism.
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The Other Side of the Market
The Role of Spending
• Total spending in a very simple economy,
we assume:
– Households Spend all income on domestic
output (no imports)
• No saving
– Domestic business firms
– No Government, no taxes
– No exports or imports
• With these assumptions, total spending
must be equal to total output
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Total Spending in a Simple Economy
An economy producing total output of $10 trillion will, by
definition, creates $10 trillion in total income (factor payments).
If households spend all of this income on consumption goods,
then total spending will equal $10 trillion as well.
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The Role of Spending
• Say’s law (J.B. Say,1821)
• By producing goods and services (i.e.,
supply) firms create a total demand for
goods and services equal to what they
have produced
• Supply creates its own demand
• Full-employment can be maintained
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Total Spending in a More Realistic Economy
• Assumptions
– Still a closed economy (no imports or
exports)
– But now have government
• Collects taxes and purchases goods and
services
– Households save
• Households no longer spend their entire income on
consumption. Some is saved and they pay taxes
– Business firms
• Purchase capital goods (investment spending)
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Example: Flows in the Economy of Classica, 2012
Actual and Potential Output (GDP)
$10 trillion
From the production
function
Total Income (Y)
$10 trillion
Y = output = GDP
Consumption Spending (C)
$7 trillion
Households don’t spend
all of their income
Planned Investment Spending (Ip)
$1 trillion
Business planned
investment
Government Purchases (G)
$2 trillion
Net Taxes (T)
$1.25 trillion
Disposable income (Y – T)
$8.75 trillion
Total income (Y) less
taxes (T)
Household Saving (S)
$1.75 trillion
Y-T-C
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Important definition!
Planned investment spending (IP)
• IP = Business planned purchases of plant
and equipment
• Total actual investment (I) = IP+Δ inventories
• Δ inventories are treated as unplanned
investment and can be positive or negative
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A few more definitions
• Net Taxes (T)
- Total government tax revenue minus
government transfer payments
• Disposable income
– household income minus net taxes (Y – T)
– after tax income
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Household Saving (S) in our More Realistic Economy
• Household saving (S)
- portion of after-tax income that
households do not spend on consumption
S = Disposable Income – C
S = (Y - T - C)
• Household saving in Classica
S = (Y - T - C)
= $10 - $1.25 - $7
= $1.75
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Total Spending in a More Realistic Economy
• Total spending in Classica
– Sum of the purchases made by
• Household sector (C)
• Business sector (IP)
• Government sector (G)
• We assumed no exports or imports
• Total spending = C + IP + G
= $7 + $1 + $2 = $10
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